The ins and outs of intercompany netting

The world is an increasingly complex place and so is its commercial network: there are estimated to be about 60,000 multi-national corporations worldwide, controlling more than 500,000 subsidiaries, imposing an onerous set of obligations upon those company’s treasury operation.

The same applies to companies which only operate in one country; they may also have a network of subsidiaries with labyrinthine funding needs which have grown exponentially over the decades.

One of the structures put in place to deal with hugely complicated treasury functions is ‘intercompany netting’: an arrangement between the subsidiaries in a corporation in which each makes payments to, or receives payments from, a clearing house (the netting centre) for net obligations from fellow subsidiaries.

Namely, it is the offsetting of accounts receivable and accounts payable between all business entities within the same organisation.

This not only increases efficiency, but also reduces credit/settlement risk. The bank fees involved are also lower. At a time when both transaction fees and currency exchange risk is growing, and lack of transparency is commonplace, netting could be the answer.

Intercompany netting comes in many forms. Firstly, there is bi-lateral (two companies) and multi-lateral (three or more companies) netting which is used in the management of cross border payments where net receipts or payments can be settled in their local or preferred currency.

Multinational companies often perform transactions with their own subsidiaries or with non-group companies based in different countries. Because of this, companies must keep currency exchange rates in mind. Currency, or foreign exchange, netting allows corporates to offset accounts payable in one currency with accounts receivable in the same currency.

For example, a German entity operating in euros may need to settle with a Singapore entity in Singapore dollars, while the same Singapore entity may need to settle and invoice with a UK entity in pound sterling. The German company might owe S$1,500,000, the equivalent to just over €1,000,000, while the Singapore entity might owe £5million.

These are separate transactions, all involving forex and transaction risks. Were the FX exchanges involved in the transactions, the FX exposures and requirements would no longer be the responsibility of individual entities, but for the group as a whole. Clearly, this is especially useful for multi-national corporations.

At the centre of all this sits the netting centre, which determines the amounts owed or due, and makes the fund transfers. The counterparties involved send their invoices to the netting centre, which are then verified, and any disputes resolved. Once the invoices have been tallied, the netting centre will make the appropriate payments in the appropriate currency. Money owed will be used for payments elsewhere.

Setting up a multilateral netting centre and system means all the exposures are consolidated at a group level, and treasury teams have a clear picture of those exposures and what is required to settle them for all the entities. Foreign exchange risk therefore is centralised, and treasury departments will likely spend less time on transactions and managing foreign exchange risk as a result.

Foreign exchange risk can be better hedged and mitigated; rather than spread across a network of subsidiaries it can be centralised in the netting centre. The parent company will almost certainly be able to operate on better terms than a subsidiary and there is no further need for an external foreign exchange centre.

Why netting?

 The benefits of netting are clear and extensive. In the first instance, fees are lower and treasury officials can better allocate their time due to efficiency gains.

For example, netting results in potential mistakes coming to light much more quickly. In general, treasury departments set up rules for managing disputes when setting up a netting system.

When subsidiaries fail to submit payables, a discrepancy in the payment process is logged. Administrators are then able to set up automated escalation protocols, which will alert upper management to the payment issues based on pre-defined metrics. As a result, treasury teams can spend less time dealing with disputes due to an automated process being in place.

Netting also increases transparency. When subsidiaries are engaged in bulk payments, treasury departments may struggle to react to liquidity or financing challenges if company-wide visibility if lacking. This can lead to bulk payments backloading, in turn causing cash flow problems.

A netting system provides daily reports and monitoring tools which provide treasurers with cash flow visibility across the group. The reports include details of dates, currency conversion rates, and the details of the transaction – helpful for an organisation’s auditors.

Other benefits include reducing the number of intercompany cashflows to each subsidiary; simplification of the financial processes; streamlining invoice reconciliation between companies and the quarterly reconciliation of accounting ledgers.

Because not all netting systems are the same, a TMS (Treasury Management System / Financial Risk Management Software Solution) needs to be able to offer flexibility in the way it can facilitate a treasury teams requirement in terms of the configuration, workflow and the controls in order to be able to best meet not only todays needs, but also be in a position to evolve for future advancements in technologies and strategies.

Solutions in focus

Salmon Treasurer supports the entire in-house banking process including a dedicated multi-lateral intercompany netting module. This allows for both payables and receivables driven netting including both intercompany and external invoices. The netting process includes defining netting cycles, dispute resolution with a full comment history, multi-stage approvals and workflows and the ability to customise netting rulesets.

Multiple netting centres can be involved and the participants defined, including their default settlement currencies and accounts, as well as support for non-cash settlements which will automatically effect the intercompany position. In the case of cash settlements, these automatically feed into the electronic payments and settlements capabilities of the treasury system including the same workflows and security as any other settlement processed by Salmon Treasurer.

The system also produces a wide variety of reporting and dashboarding to provide analysis on the netting process including automatic distribution of netting statements to the participants. The underlying invoices to be netted can be uploaded automatically from a wide variety of sources including ERPs, meaning that a proper straight through the process can be achieved, including granting subsidiary participants access to view, dispute and resolve as appropriate through the browser based Salmon Treasurer Portal.

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